What is Ratio Analysis?
The use of ratios is the bedrock of fundamental analysis. Calculated with the use of financial statements – balance sheet, P&L, and cashflow statement – they aid outside analysts in assessing a company’s liquidity, margins, profitability, rates of return, valuation, and more. Corporate management relies on them less since they have access to more detailed data about a company.
There are 4 main ratio categories:
- Liquidity
- Profitability
- Debt and Leverage
- Activity
Why is Ratio Analysis important?
Ratio Analysis is essential in understanding the core capabilities of a business. It permits analysts to gather insights into companies’ performance and overall health. They are necessary to compare entities or institutions of varying sizes and simplify large dollar amounts reported in the financial statements into neat and easy-to-understand values.
Limitations and resolutions
One single ratio is most often not enough to fully describe and understand a company. Suppose that your student grade point average for the last semester was 3.8/4.0. This GPA is certainly impressive, but not that useful. It does not give me any relevant information about your work as a student.
To get a better picture, I may want to know what your GPA was in in the last three semesters. Did it improve, or did it get worse?
Also, I may want to know the GPA of other students in your class, especially those that took similar subjects and courses. Do you outperform or underperform your peers?
In essence, to fully understand your academic abilities, I need to figure out the trend that underlines your GPA and compare it to other students. In finance and business, the same concepts apply.
Ratio analysis is useful when used in the following two ways:
- Calculating the trend line of each ratio over a significant period (4 + years) to see if there is a defined trend, which can identify financial troubles or prosperity. They can also be used to estimate future ratio performance.
- Analyzing an individual company’s ratios with the comparable competitors and industry ratios. Given that business operating in the same industry have similar assets and capital structure, the results should be alike. If this is not the case, it could mean that a company is underperforming, or the reverse.
Liquidity Ratios
Liquidity, per se, describes the degree to which an asset or security can be readily converted into cash. In the case of business entities, the definition changes a bit, but the core concept remains. Indeed, liquidity refers to a firm’s ability to meet its current obligations (does the firm have enough cash to pay off its short-term debt?).
Current assets and current liabilities are often used to measure liquidity. The reason being both represent short-term benefits (e.g., Accounts Payable) and obligations (e.g., Accounts Payable).
Common liquidity ratios include:
- Current Ratio = Current Assets/Current Liabilities
- .Acid-Test Ratio = Current Assets – Inventory / Current Liabilities
Profitability Ratios
Profitability measures a firms’ ability to generate earnings relative to revenue, equity, assets, costs, and more. If you are considering two investment alternatives, you may want to analyze their profitability. You may want to understand which one among the two will yield better gains for you and why, and profitability ratios can help you with that.
Common profitability ratios include:
- ROI = Net Income / Total Assets
- ROE = Net Income / Total Equity
- Margin = Net Income/Revenue
- Earnings per Share = Net Income / Share Outstanding
- Price-Earning Ratio = Share Price / Earnings per Share
- Dividend Yield = Dividends per Share / Share Price
Leverage and Debt Ratios
Leverage is a fancy term to describe the financing of assets through debt. Leverage magnifies ROE (Return on Equity) and ROI (Return on Assets), as the cost of debt (i.e., interest) is a fixed charge.
Nonetheless, it also adds risk to the operation of a firm. After all, if a firm does not generate enough cash to pay its debts, creditors may force it into bankruptcy.
It is therefore important to use financial metrics that indicate the extent to which a firm is using leverage. Common leverage and debt ratios include:
- Debt Ratio = Total Liabilities / Total Assets
- Debt-Equity Ratio = Total Liabilities/ Total Equity
- Times Interest Earned = Operating Income / Interest Expense
Activity Ratios
Investors use activity ratios to understand how well a company is employing its assets and resources. They help in evaluating a firm’s overall operating efficiency by analyzing Plant and Equipment, Inventories, Receivables, and more. As such, they are often called efficiency ratios.
The most common activity ratios include:
- Assets Turnover = Revenue / Average Assets
- Inventory Turnover = Cost of Good Sold / Average Inventory
- Receivables Turnover = Revenue / Average Accounts Receivable
- Plant and Equipment Turnover = Revenue / Average Plant and Equipment
- Average Day’s Sales = Annual Revenue / 365
- Days’ Sales in Accounts Receivable = Accounts Receivable * 365 / Annual Revenue
In a Nutshell
Test yourself!
Public companies usually publish their financial statments on a quarterly and annual basis. You can find US-based public company’s balance sheets on the US Securities and Exchange Commission (SEC) website. Search for the 10-K, and you will be ready to go!
